An Exchange Rate Model with Market Pressures and a Contagion Effect

ABSTRACT

The model we propose includes variables accounting for the behavioral aspects of decision-making in the currency markets, namely the contagion effect between countries in the same region. It combines the classical purchasing power parity (PPP) and uncovered interest rate parity (UIP) hypotheses with the effects of risk aversion in financial markets and of currency market pressures.

The results based on the Polish data confirm that the currency market instabilities arise not only from fundamental factors such as economic activity and the country’s balance of payments, but also from the contagion effect brought about by investors’ tendency to view Poland and its neighbors, the Czech Republic and Hungary, as one group.

KEY WORDS:

• Binomial variables
• cointegration
• contagion effect
• exchange rate models
• herding

JEL:

• C32
• C35

Acknowledgments

We are indebted to anonymous referees for their critical comments. We wish to acknowledge our gratitude to Aleksander Weron, Ryszard Doman, and Janusz Brzeszczyński for their valuable suggestions on the earlier version of this article. We have also benefited from discussions conducted during the seminars at the Hugo Steinhaus Center, the Institute of Mathematics of the Polish Academy of Sciences, the National Bank of Poland, the Macromodels International Conference, and the Neoclassical and Behavioral Finance International Conference. Any errors are the sole responsibility of the authors.

Funding

Support from the National Science Center, Poland (NCN) grant MAESTRO 4 DEC-2013/08/A/HS4/00612 is gratefully acknowledged.